Biotech’s New Normal

Early-stage companies are front and center as investor appetite increases and competition heats up

January 5, 2015

As Biopharmaceutical companies think about tapping equity markets or exploring M&A, recent patterns suggest that those key decisions may be more or less beneficial at certain stages of the development process. While conventional wisdom holds that later-stage companies are more likely to maximize their value through an equity offering or a strategic sale, recent data shows that Pre-clinical and Phase I companies can generate as much or more value than their later-stage competitors in transactions. Indeed, the recent market trends are challenging assumptions about when and how to maximize value through deal activity.

Investor Appetite for Early-Stage New Issues Increases

If 2013 was considered a good year for Biotech IPOs, then 20141 was a great year. There were ten Pre-clinical and Phase I IPOs in 2014, raising more than $900 million – robust activity for early-stage issuances. According to Dealogic and Factset data, the Pre-clinical and Phase I IPOs of 2014 have performed on par or better than the Phase II and Phase III new issues. As of Dec. 31, 75% of the Pre-clinical names and 67% of the Phase I names were trading above their offer price compared to 50% of Phase II and 61% of Phase III new issues.

Performance analysis along the same lines for the 2013 class of IPOs reveals the earlier-stage companies actually performed better. Remarkably, 100% of the Pre-clinical and Phase I IPOs of 2013 were trading above their offer price as of Dec. 31. That compares to 59% of the Phase II IPOs and 73% of Phase III IPOs. Additionally, the share prices of 2013 Pre-clinical and Phase I IPOs are up nearly 370% and 120%, respectively, from their offering price, handsomely rewarding those who’ve invested in and held the assets since going public.

While these numbers might suggest that no one is penalized for investing in earlier stage companies, the overall volatility of equity markets is a key factor. Volatility in the equity markets has been relatively low since 2013 and, overall, decreasing. With more stable markets, investors show more appetite for risk, and in this case, more willingness to take a chance on an earlier stage company. But if that volatility outlook should change, so too could the appetite of investors.

While similar performance analysis is difficult to provide for recent follow-on activity, potential issuers should note that the number of fully marketed offerings is on the rise. In 2014, these deals were nearly as prevalent as overnight or confidentially marketed offerings, halting a four-year trend.

For small- and mid-cap companies pursuing a fully marketed offering, there is still a larger file-to-offer discount as compared to an overnight or confidentially marketed deal, but that difference is narrowing. According to Dealogic, the median discount between a marketed deal and an overnight deal since 2012 is just two to four percentage points. This suggests that companies should more strongly consider the benefits of a fully marketed deal. While there may be an upfront cost, it is a relatively small price to pay to share your business’ story with a broader group of investors and generate interest ahead of a public offering.

M&A: Large pharma driving deal flow with larger upfront payments

20142 was a blockbuster year for Healthcare M&A, with 565 announced deals in Biotechnology, Pharmaceuticals and Life Sciences. That environment will likely continue in 2015 as industry consolidation drivers continue and favorable macro conditions persist.

One M&A trend we expect to continue is increasing upfront payments and the use of option agreements. Thanks to very solid balance sheets and competitive industry pressures, large pharma has a significant desire and financial capacity to acquire “must-have” assets. For example, in 2014, the average upfront payment for an option agreement was $62.7 million, according to Thomson Reuters – not as high as the $72.9 million average from 2013, but well above the $29.8 million and $38.2 million averages from 2012 and 2011, respectively.

Previously regarded as a form of alternative financing, Biotech companies are increasingly using these option agreements as an effective way to set an acquisition price before data is revealed. The robust M&A activity has piqued the attention of investor activists, unfriendly suitors and corporate boards. Given the significant increase in public market value that occurs when a company releases data, corporate boards fear their companies are currently undervalued by the market and are taking actions to put protective measures in place.

Companies with significant near-term clinical milestone(s) should consider themselves a potential target, review their strategic options and revisit their takeover defenses. In order to successfully fend off a hostile or unsolicited takeover attempt, companies must set a record with their board while reviewing their defense mechanisms such as a poison pill or staggered board.

Outlook for 2015

While it is always difficult to predict future market conditions, we anticipate a good environment for new Healthcare issues and M&A deals in 2015. Although there are a variety of macro issues that could prompt another spike in volatility, we believe the Fed will continue to be accommodative and the U.S. economy will continue to grow slowly and steadily. We believe the M&A market will continue to be competitive in the new year. Targets in the cardiovascular, cancer, central nervous system (CNS) and autoimmune spaces will be attractive to potential buyers.